Lemonade Inc. IPO Will Be Hot, So Be Patient

We were looking through recent IPOs, some of those covered in our previous note, but a more exciting one is the one coming soon – Lemonade Inc. (NYSE: LMND). Even though the company offers renters and homeowner insurance, if you are expecting insurance like business valuation, you will be in for a surprise. Case in point insurance comparison sites SelectQuote (Nasdaq: SLQT) and EverQuote (Nasdaq: EVER)

Other than profitability almost everything that excites growth-oriented investors is going for this ‘insurtech’ play, companies combining insurance and technology. Extremely high sales growth, almost 200% during 2019, the secular trend of using technology to sell insurance and high operating leverage below the gross profit line.

As a public benefit corporation, expect the issue to be popular among socially responsible funds commanding more than $3 trillion AUM and impact investing funds, a market that has grown to $715 billion in assets under management. The issue will undoubtedly be too rich for GARP investors like us, but better to do hard work now to buy when the opportunity comes.

Next-generation of insurance

Traditional insurance names are profitable but boring. Lemonade with its contemporary design aesthetics for the website, data-driven decision-making and use of artificial intelligence to get renters or homeowners covered as well as to file claims, is clearly in a position to gain market share.

Description: Macintosh HD:Users:darspalmann:Downloads:LMND1.png
Source: SEC Filings

The average annual growth in online insurance was just 9% over last year and Lemonade can grow many times fast than that, not just gaining share in an existing category but also expanding into additional insurance categories. The online insurance brokerage market is more than $31 billion.

You will be surprised why is this company that had less than $100 million revenue last year is generating so much buzz, thank the well-heeled investors like SoftBank (9434.T), Sequoia Capital, Aleph, XL Innovate and General Catalyst Partners, who collectively have contributed more than $450 million so far.

Business model has strong legs

There are some unique features of the business model that will position the company favorably among institutional investors

  • Demographics

Approximately 70% of the company’s current customers are under the age of 35 and almost 90% of them didn’t switch from another carrier. Impressive on both company’s ability to almost create a category and sign up a generation that rarely commits as its customer base.

  • Long-tail

Another unique feature is how the company’s renter’s insurance customers increase spending their insurance policy over time. Indeed, customers who bought insurance three years ago from the company spend 56% more on their renter’s insurance now than when they first joined initially.

The median age of a customer with an entry-level $60/ year policy is 30 years, which climbs to 40 years for customers with policies of approx. $600/ year, and $6,000 a year for the median age 50 years.

Description: Macintosh HD:Users:darspalmann:Downloads:LMND.png
Source: SEC Filings

“Graduation” is when a customer upgrades their policy from a Lemonade renter’s policy to a Lemonade condo or homeowner policy. The business grows as the customer age.

  • Low volatility in margins

Starting next month, the company will start transferring 75% of the premiums received to reinsurers, i.e. proportional reinsurance structure, taking back 25% commission on the amount transferred and in return reinsurers will be responsible towards 75% of the claims. This will protect margins from the volatility of claims.

Secondly, this will free up additional capital that can be used to invest in growth initiatives. Because of the proportional reinsurance structure, the capital surplus required of the company will go down to 7:1 instead of 2:1 without proportional reinsurance.

Ignore asking about valuation for your health though

Lemonade Inc.   
    
As % of Revenue20182019Improvement with scale
Loss and adjustment expense72%72%Negligible
Other insurance expense19%14%High
Sales and marketing186%132%High
Technology development21%15%High
General and admin40%31%High
Data Source: SEC Filings

Unlike old school insurance, the company retains a fixed 25% of premiums, which is why company’s gross margins are not expected to change much and much of the operating leverage or benefits of scale will be from sharing operating costs like sales & marketing, research & development, and general & administration over a bigger pool of sales.

The business is not going to be profitable anytime soon, but given decent leverage in the model, it is apt for them to continue to spend on acquiring more customers. Applying a roughly 20% gross margin, the company earns back the cost of acquiring a customer in just over two years.

Pricing

They haven’t announced the pricing; we’ll update our model when we have more details available. Please follow our twitter feed for any updates. Given the interest in the deal, it is safe to assume that pricing would leave something for the institutional investors, but still rich for price cautious investors. So if others buying expensive things annoy you, like a lot of investors, better to ignore looking at valuation all together and just enjoy watching the excitement.

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